The Firm and Market Structures Flashcards
What is a perfectly competitive environment for firms and what does it entail for prices?
Firm operates in a market with many buyers and sellers, homogeneous products, no entry/exit barriers and perfect information. Firms are price takers, meaning they cannot influence market prices and must accept equilibrium price set by supply and demand.
What is an imperfectly competitive environment for firms and what does it entail for prices?
Firm has some degree of market power, allowing them to influence prices. This includes monopoly, oligopoly, monopolistic competition, and monopolistic dominance. Firms may differentiate products, set prices above marginal cost, and face barriers to entry that limit competition.
What does perfect competition mean for profits in the long run?
Perfect competition leads to zero economic profits in the long run.
How does the demand curve look in a perfectly competitive market?
The demand curve is flat because the price stays the same for each amount of demand. The price is the same as the firm’s Marginal Revenue and Average Revenue.
What is marginal revenue?
Additional revenue a firm earns from selling one more unit of a good or service.
In perfect competition, MR equals the market price because firms are price takers.
In imperfect competition, MR is less than price because firms must lower the price to sell additional units, leading to a downward-sloping demand curve.
How to calculate Marginal Revenue?
Change in total revenue / Change in quantity sold
How does the demand curve look in an imperfectly competitive market?
The demand curve is negatively sloping because a firm must lower its price to sell an additional unit, so MR is less than price.
How to calculate Total Revenue?
Price * Quantity
In a perfectly competitive market, as the firm sells one more unit, its TR rises by the exact amount of price per unit.
Under imperfectly competitive markets, the price is a function of quantity. P = f (Q)
How does the total revenue x quantity curve look for imperfectly competitive markets?
Parabolic. One specific quantity and price leads to highest total revenue.
What is profit maximization?
The process by which a firm determines the optimal level of output and pricing to achieve the highest possible profit.
When does a firm maximize profit in terms of MR and MC?
At MR = MC, profit is maximized because producing more would lower profit, and producing less would leave potential profit unearned.
If MR > MC, the firm should increase output to gain more profit.
If MR < MC, the firm should reduce output to avoid losses.
In imperfect competition, firms have pricing power and set a price above marginal cost (P > MC).
When does a firm break even?
If total revenue equals total costs. An economist would argue that such a firm is earning normal profit but not positive economic profit.
What is a sunk cost?
A cost that cannot be avoided and such costs must be ignored in the decision to continue to operate in the short run.
What is the shutdown decision?
If the firm can earn a positive profit, it should continue to operate both short term and long term.
If the firm cannot cover variable costs, it should discontinue operation directly.
If the firm can only cover variable costs, it should continue to operate in the short run but exit market in long run.
What is the shutdown point?
Minimum average variable costs
How to define the short run for a firm and how to define the long run?
The short run is the time period during which at least one of the factors of production, such as tech or physical capital, is fixed.
The long run is the time period during which all factors of production are variable.
What are economies and diseconomies of scale?
Economies of scale occur if, as the firm increases its output, cost per unit of production falls.
Diseconomies of scale occur if cost per unit rises as output increases.
What are the four market structures?
Perfect competition, monopolistic competition, oligopoly, and monopoly
What is the definition of a market?
Group of buyers and sellers that are aware of each other and can agree on a price for the exchange of goods and services.
If the service being provided by the seller can be digitized, its market expands worldwide!
What is a market with perfect competition?
Perfect competition features many firms selling homogeneous products with no market power. Firms are price takers, and long-run profits are zero due to free entry. Example is commodity markets.
What is a market with monopolistic competition?
Monopolistic competition has many firms selling differentiated products. Firms have some pricing power, but easy entry drives long-run profits to normal levels. Examples are fashion or cosmetics
What is an oligopoly market?
Oligopoly consists of a few dominant firms with interdependent pricing. High barriers to entry allow for sustained profits, and firms may engage in strategic behavior. Example are airlines
What is a monopoly market?
Monopoly is a single firm controlling the market. With no competition, it sets prices above marginal cost and can earn long-term economic profits. Example is local electrical power provider
What are the five factors determining market structure?
- Number and size of firms supplying the product.
- Degree of product differentiation.
- Power of the seller over pricing decisions.
- Relative strength of entry/exit barriers to market.
- Degree of non-price competition.
Tradeoff between perfect competition which leads to lots of goods for low prices, and monopoly which may spur innovation more.
What are Porter’s Five Forces?
Threat of Entry
Power of Suppliers
Power of Buyers
Threat of Substitutes
Rivalry among existing competitors
What are the three pricing strategies in an oligopoly?
Pricing interdependence
Cournot assumption
Nash equilibrium
What is pricing interdependence?
Firms consider rivals’ reactions when setting prices. A price change by one firm often leads to similar responses from competitors, creating stability or price wars.
What is the Cournot assumption?
Firms compete by choosing output levels, assuming rivals keep their output constant. Each firm adjusts output to maximize profit, leading to an equilibrium where no firm benefits from changing its quantity alone.
What is the Nash equilibrium?
Firms make the best possible decisions given their rivals’ choices. No firm can improve its outcome by unilaterally changing its strategy, leading to a stable competitive balance.
What is the Stackelberg Model?
A form of oligopoly where firms compete on quantity, but unlike Cournot, one firm (the leader) moves first and sets its output level. The follower then optimizes its quantity based on the leader’s decision. This gives the leader a strategic advantage, allowing it to achieve higher profits than in the Cournot model.
Oligopolistic pricing strategies lead to kinked demand curves!
What is collusion?
An agreement between firms in an oligopoly to restrict competition by coordinating prices, output, or other market strategies. This can be explicit, through formal agreements like cartels (e.g., OPEC), or tacit, where firms follow each other’s pricing without direct communication. Collusion leads to higher prices, reduced consumer choice, and greater profits for firms but is often illegal due to its negative impact on market efficiency and consumer welfare.
What is the concentration ratio and how to calculate it?
The sum of the market shares of the largest N firms.
Number is zero for perfect competition and 100 for monopoly.
What are an advantage and two disadvantages of concentration ratio?
Easy to compute but not directly causal to market power, because being the only one in the market does not automatically mean there are high entry barriers. Also, unaffected by mergers among top market incumbents.
What is an alternative for the concentration ratio?
Herfindahl-Hirschman Index (HHI)
What is the Herfindahl-Hirschman Index (HHI) and how to calculate it?
A measure of market concentration used to determine the level of competition in an industry. It is calculated by summing the squares of the market share percentages of all firms in the market.
HHI < 1500 = competitive market
HHI > 2500 = less competitive (highly concentrated)
What is a disadvantage of the HHI?
Fails to reflect low barriers to entry
